Emerging market dilemma: the paradox of global capital flows.

• Author: Gallagher, Kevin P.

In 2012, Brazilian President Dilma Roussef scolded Fed Chairman Ben Bemanke's monetary easing policies for creating a tsunami of financial flows to emerging markets that was appreciating currencies, causing asset bubbles, and generally exporting financial instability to the developing world.

Now, as growth increases in the United States and interest rates follow, the tide is turning in emerging markets. Many countries may be facing capital flight and exchange rate depreciation that could lead to financial instability and weak growth for years to come.

The Brazilian president had a point. Until recently, U.S. banks wouldn't lend in the United States despite the unconventionally low interest rates. There was too little demand in the U.S. economy and emerging market prospects seemed more lucrative.

From 2009 to 2013, countries such as Brazil, South Korea, Chile, Colombia, Indonesia, and Taiwan all had wide interest rate differentials with the United States and experienced massive surges of capital flows. The differential between Brazil and the United States was more than 10 percentage points for a while--a much better bet than the slow growth in the United States.

According to the latest estimates by the Bank for International Settlements, emerging markets now hold a staggering $2.6 trillion in international debt securities and $3.1 trillion in cross border loans--the majority in dollars.

Official figures put corporate issuance at close to $700 billion since the crisis, but the BIS reckons that the figure is closer to $1.2 trillion when counting offshore transactions designed to evade regulations.

Now the tides are turning. China's economy is undergoing a structural transformation that necessitates slower growth and less reliance on primary commodities. Oil prices and the prices of other major commodities are stabilizing or on the decline. It should be no surprise then that many emerging market growth forecasts are continually being revised downward. Meanwhile, growth and interest rates are picking up in the United States. The dollar gains strength, the value of emerging market currencies falls.

Some analysts predict that emerging market and developing countries can weather the storm through floating exchange rates, the development of local bond markets, interest rate hikes, or by using some of their foreign exchange reserves. These tools are important, but may not be available or enough.

Floating exchange rates and the resulting depreciation...